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Graphical models for correlated defaults

  • I. Onur Filiz
  • Xin Guo
  • Jason Morton
  • Bernd Sturmfels
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    A simple graphical model for correlated defaults is proposed, with explicit formulas for the loss distribution. Algebraic geometry techniques are employed to show that this model is well posed for default dependence: it represents any given marginal distribution for single firms and pairwise correlation matrix. These techniques also provide a calibration algorithm based on maximum likelihood estimation. Finally, the model is compared with standard normal copula model in terms of tails of the loss distribution and implied correlation smile.

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    Paper provided by in its series Papers with number 0809.1393.

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    Date of creation: Sep 2008
    Date of revision:
    Handle: RePEc:arx:papers:0809.1393
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    1. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
    2. Jeffery D Amato & Jacob Gyntelberg, 2005. "CDS index tranches and the pricing of credit risk correlations," BIS Quarterly Review, Bank for International Settlements, March.
    3. M. Davis & V. Lo, 2001. "Infectious defaults," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 382-387.
    4. Robert A. Jarrow, 2001. "Counterparty Risk and the Pricing of Defaultable Securities," Journal of Finance, American Finance Association, vol. 56(5), pages 1765-1799, October.
    5. Giesecke, Kay & Weber, Stefan, 2006. "Credit contagion and aggregate losses," Journal of Economic Dynamics and Control, Elsevier, vol. 30(5), pages 741-767, May.
    6. K. Kitsukawa & S. Mori & M. Hisakado, 2006. "Evaluation of Tranche in Securitization and Long-range Ising Model," Papers physics/0603040,, revised Sep 2006.
    7. Yu, Fan, 2005. "Accounting transparency and the term structure of credit spreads," Journal of Financial Economics, Elsevier, vol. 75(1), pages 53-84, January.
    8. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
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